Commentary on Economics, Information and Human Action

Shale gas glut, but won’t last? The underlying model

Ken Silverstein has a good article in Forbes on the business prospects for shale gas developers (and I’m glad to see him there, having followed his work for a very long time). Since he asks in the title whether low shale gas prices are a mirage, I think it’s useful to go through the underlying economic analysis that’s embedded in his article. Note: if you are a principles student, this is a good exercise for you, because there will be a lot of shifting of supply and demand curves.

We start with the current boom in shale gas production, the consequence of technological change — horizontal drilling makes gas deposits available that were not with conventional technology. How do we model technological change? As an outward shift/increase in the supply of natural gas; at every price the quantity supplied is now greater, at every quantity the supplier’s marginal cost has fallen. For a given demand in the natural gas market, moving along the demand curve toward the new equilibrium means that price falls and quantity of gas sold and consumed rises. That’s a good model of where we are now.

But this equilibrium is unlikely to persist. Why? Because people don’t consume natural gas in isolation; we make decisions at the margin about when to substitute natural gas consumption for other fuel consumption, depending on the relative prices of those fuels. Even assuming all other things equal (a strong assumption), the falling price of natural gas will make the relative price of coal (Pcoal/Pnatgas) go up. Natural gas has become cheaper relative to coal, and at the margin consumers will substitute out of coal and into natural gas, even barring any other changes. We model this effect as a decrease in demand for coal, a leftward shift in the demand curve. For a given supply of coal, that means a lower price of coal (bringing their relative prices back into some balance that I won’t bore you with here) and lower quantities of coal consumed. In the short run that happens by substitution where it’s easiest, in industries using technologies (engines, turbines, smelters, etc.) where it’s relatively easier to switch between fuels.

Note also that regulatory changes, such as environmental regulations to reduce greenhouse gas emissions, will exacerbate the substitution out of coal, and shift the demand for coal even further to the left.

Another important factor in a dynamic economy is time, and the fact that over time, by adapting to these changes, people create new changes. One such change that Ken focuses on in his article is the extent to which electricity generators will, over time, retire coal generators and replace them with natural gas turbines. The longer-run effect of a low natural gas price (and low natural gas price relative to coal, so it’s in both absolute and relative terms) is the replacement of more durable, longer-lived technologies that use coal. Note the win-win here: not only is it cheaper (all other thing equal) to generate electricity with gas because of the shale gas, it’s also a cheaper way to meet environmental regulations because of the lower carbon footprint of natural gas. How do we model this effect? As an increase in the demand for natural gas, a rightward shift in the demand curve. So now in the natural gas market we have had an increase in supply and an increase in demand (yes, you should be jotting down graphs here!).

What do we learn about increases in supply and demand in the same market? The quantity transacted goes up, unambiguously. But price can go up or down relative to the initial price. That’s what we’ll see play out over the next several years, as electricity generators build more natural gas capacity and retire coal capacity. The empirical question will be whether or not the size of the increase in their demand outweighs the size of the increase in supply. That interaction will determine whether or not the current low prices are a mirage, although I admit that I object to that language in describing them; they aren’t a mirage, because they are real. But they are probably temporary. However, even if prices go up because of generator demand for natural gas for electricity, consumers benefit through controlling the economic and environmental costs of electricity generation. It’s just that their benefit will show up there instead of in the reduction in their home heating/stove bills. But don’t let the “mirage” framing of this point trick you into thinking that generator demand for natural gas is bad for consumers.

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5 thoughts on “Shale gas glut, but won’t last? The underlying model”

I’d add one more supply/demand dynamic to the math – namely the supply of capital to the shale gas producers. CHK is consistently delivering a negative return on equity, suggesting that it’s investors are willing to oversupply $ today, presumably on the hope that the leases and/or other first-mover advantages will reap rewards when the later prices rise. But that can’t continue indefinitely, and at some point either the price of gas must rise or else the supply of capital for continued drilling will fall.

Other aspects. 1) Several years ago most, if not all, operators in the “horizontal tite gas plays” all across the country signed 3 year leases with their mineral owners. The leases also contain a continuous drilling provisions to extend drilling past the primary term. These provisions are meant to allow the operator to continue “earning” statutory spacing units of acreage by a continuous drilling program. Once they stop drilling, they lose the right to drill on the remaining “unspaced” acreage. As you have seen, it has been a rush to get the needed wells drilled because of these & other lease terms. Scatter shot drilling is going to bring gas to market. Once the “drilling land rush” has been completed and the operator sees their operating margins, they will then decide what makes economic sense going forward (drill or cut bait & bail).

2) With a few exceptions, these new horizontal completions decline like there is no tomorrow. Initial declines are sold to be 35-60%/yr on a “type curve” analysis, which is a significant yearly decline for a “power source” even at these percentages. Many of the wells have experienced much greater actual declines than the type-curve during from the first 6 months to the first year. Once the flush volumes have been produced, the decline for the future is a guess..No one has produced a horizontally completed, non-reservoir rock for much longer than 3-4 years. MOST forecasts assume as time progresses, the decline decreases while costs remain constant;

3) Costs to drill & complete and operate these wells has to come down to be economic. I’m sure you have heard all the operators talking about their superior operating prowess. Which industry do you know that, has environmental, legal, operational, equipment, staffing, and stock holder demands that can lower their ultimate operating costs? Now throw in a hostile federal government. Where do you think costs/prices are going?

It’s usually a good pedagogical idea to make all quantity responses to prices movements along a curve, rather than by shifting a curve; shifts should be reserved for exogenous shocks. You could do that in your description by invoking the long-run demand curve, which is more elastic than the short-run demand curve. So the current glut leads to an immediate response down the SR demand curve (holding generating capacity fixed) but allowing capacity substitution in the long run entails movement down the flatter LR demand curve.

I think the along-the-curve vs. shifting curve stuff confuses a lot of students if not done carefully and some conclude that the whole apparatus is BS where you can make it come out however you want by shifting curves at will.

we have had an exogenous shock. the long run demand curve is about to change (slowly at first, awaiting infrastructure then, Katie bar the door). I’m not so sure that’s the best idea for fuel cost stability though..